The sell-off on the Turkish lira continues. The exchange rate against the dollar was above seven (7.2 in Asia) last night, it it now at 6.85 (just before 0400 pm, Paris time today) while it was at just 5.15 a week ago.
The graph is impressive and shows that the situation has dramatically changed in recent days.
On Turkey there are many things to look at to understand the recent weakness.
1 – In many other emerging countries, the situation has changed in April when the US dollar went up as expectations on the Fed’s monetary policy changed. Emerging currencies became weaker.
2 – The direct consequence was capital outflows from emerging to the US and lower liquidity on fixed income markets. In many emerging countries interest rates, short and long, went up rapidly. I have written on this topic here and here.
3 – The story stopped there in many countries notably in Asia. The situation is less comfortable but manageable. For countries with deficit in the current account and large indebtedness in dollar the situation went worse. This was notably the case for Turkey but also for other countries like Argentina or Indonesia. I have written on Turkey here and here

In other words, the Turkish lira weakness seen after mid-April was just the result of a stronger dollar leading to an emerging crisis. The specific Turkish momentum came from large disequilibria (current account and dollar indebtedness) that reflect the economic policy of recent years.
The recent exchange rate profile came after tensions with the US but the currency was already weak for reasons explained above. Tensions have created a run, leading to a rapid depreciation. Continue reading →

The dollar has been gaining ground since mid-April, with investor perception that the Fed would take stronger and swifter action than expected, and this raises a number of difficulties for emerging markets.

The greenback’s surge against all other currencies is a game changer for emerging countries for at least three reasons: expectations of a swift rate hike from the Fed generally trigger capital outflows from emerging countries, which is what we are currently witnessing; the situation also hampers economic prospects due to insufficient liquidity and the ensuing rise in interest rates; these factors combine to further push the currency down and thereby increase the cost of paying off dollar-denominated debt (read my posts here and here to find out more about this deterioration).

This situation is particularly worrying when the current account balance (which reflects a country’s external relationships) displays a deficit, as the flipside to this is high external debt and a situation that is set to deteriorate even faster than elsewhere. This raises the question of financing the current account at a time when the country is suffering capital outflows, and the country in question generally has to up its interest rates considerably, pushing its economy into a downward spiral and ultimately locking it into a crisis.

We have witnessed this situation recently in Argentina, Turkey, Indonesia, South Africa and some other countries, and there is nothing unusual about it, but it is very a costly experience for countries hit by this adjustment.

At this juncture, I feel it is interesting to identify the mechanisms involved in this type of crisis by taking the example of Turkey. The country is currently undergoing this type of adjustment in a very dramatic way and the situation is made even more complex by the prospect of early presidential elections on June 24.